Capital Raising

Flat is the new up

The startup ecosystem has a painful year ahead. Nearly half of Series C fundraising rounds were down or flat in 2016. Series B startups are next in line to feel the pain. [A] flat [round] is the new up [round]. If you really need another venture acronym, call it FITNU.

The market correction will not stop at Series B. If you’ve raised a Series A and need more capital in 2017, what I’m going to share might save your company. If you’re at the seed stage, this article might save you a lot of trouble.

Wait, what happened?

According to some investors, 2017 was supposed to be the turnaround year. Didn’t U.S. venture capital funds raise a record $42 billion in 2016? Didn’t we get past the notorious bubble?

Not quite. The bubble broke in 2015 when the tourist VCs driving unicorns in so-called private IPOs got spooked. They pulled back. This ratcheted down the VC food chain. The system couldn’t support the wild number of seed deals and high valuations. To protect itself, the system concentrated more money into fewer deals.

PitchBook found that the number of U.S. seed rounds declined 43 percent, from 1,537 deals in Q2 2015 to 872 in Q4 2016 — a four-year low. Early-stage financing (Series A and B) followed along. Deal volume tanked from 830 in Q2 2014 to 524 in Q4 2016.

Meanwhile, deal sizes swelled. Indeed, 42 percent of seed rounds were between $1 and $5 million in 2016, the highest proportion PitchBook has recorded over the past 10 years. Almost 50 percent of the early-stage money went into rounds worth $25 million or more in 2016.

Corroborating PitchBook, Redpoint Venture’s Tomasz Tunguz points out that the median seed round tripled, from $272,000 to $750,000 between 2010 and 2016. His analysis of Crunchbase data also shows that the median A round climbed from $3 million to $6.6 million over the same span, and the median B leapt from $10 million to $15 million.

So why the flat rounds?

In the bubble, more startups received seed funding because so many new seed venture firms entered the business. But the number of Series A firms didn’t grow much at all — they just raised bigger funds. Thus, Series A firms started writing bigger checks to meet the needs of their business.

Unfortunately, few seed startups qualify for $10 million to $20 million “Super-Sized” A rounds. As a result, the seed-to-A graduation rate plummeted. Series A follow-on investments dropped from roughly 25 percent in 2012 to less than 10 percent as of midway through 2016, says PitchBook. Over time, a lot of the seed-funded companies get extensions, so the graduation rate is probably closer to 20 percent. This is well below what it used to be, at 45-50 percent.

Plenty of companies took premature, massive A rounds and guzzled capital all the way to Series B. They became the source for all those flat and down C rounds. As I said, nearly half of C rounds were down or flat in Q3 2016.

Let me illustrate why. At the Series A, let’s say an investor buys 25 to 30 percent of a company and puts in $10 million. That defines the value as $33 million to $40 million post-money. B-round investors want to see at least a twofold increase from the post-money A to pre-money B. If not, they calculate they’re better off waiting for the C round.

In bubbly conditions, getting the 2x increase in valuation was easy. Startups hit their B. Then the market correction began, so they went flat or down at C. The flat and down rounds will sweep down from Series C to B to A to seed. In other words, winter isn’t over, Mark Suster.

Reseeding

In 2017, Series A companies will struggle to get their pre-money valuation high enough for the B round. If you take a flat or down round, it’s time to “reseed.” Effectively, you need to cut costs until your company resembles a post-seed startup.

Many founders think it’s “death” to take a flat or down round. They believe that partly because of equity dilution and partly because of signaling.

No company ever went bankrupt because of dilution. The real signal is what a company looks like after a flat or down round. Did it restructure to match the new reality? If so, it’s a more attractive company. The down round isn’t the problem as long as the company adopted a leaner, more sustainable model.

The capital structure is the hardest issue to solve because there can end up being too much preference from the Series A. Imagine you do a $2 million seed, and the investor has $2 million of preferred stock. Then you raise a $10 million Series A, and the A-round firm has $10 million in preference. You have a total $12 million in preference with a debt component that has to be paid back.

Sane investors don’t want $12 million in preference ahead of them at post-seed values. Even worse is getting the B round and having to reseed. You now have to deal with $25 million or more in preference. Take care of it. Do whatever it takes to reduce preferred stock in the capital structure when you reseed. That’s a harder problem to solve than your burn rate.

Next to bat

“Flat is the new up” is one way to describe the post-bubble correction. Star companies of 2014 and 2015 took flat or down rounds for their Series C. Startups that raised, say, a $1 million seed and $10 million Series A are now going through it at the Series B. Many will reduce employees and restructure their cap tables until they resemble post-seed companies. Reseeding is better than going down in flames. And, paradoxically perhaps, you might find that you grow faster with fewer employees and less internal contention. Maybe the premature Big A wasn’t such a good idea after all.

Like this:

Bubble Indemnity

When Silicon Valley venture capitalists get themselves into image trouble, it’s usually because they’ve been too candid with their low estimate of other people’s intelligence. For example, after India recently prevented Facebook from offering free Internet service there, Marc Andreessen suggested in a tweet that the subcontinent might be better off had it remained under colonial administration. It’s much less common for V.C.s to soil their own nests in public. So it came as something of a surprise when Chamath Palihapitiya — Sri Lankan war refugee, early Facebook employee, investor in Slack and Box, part owner of the Golden State Warriors — told Vanity Fair in March that if we are in fact in the early stages of a second tech collapse, venture capitalists have only their own mediocre, clubby selves to blame. They should, he said, “focus on using capital as a way to take really big bets on things that just seem totally audacious. Right now we haven’t done enough of that, and the result is that most of the things we’ve funded are mostly crap and largely worthless.”

It was a striking admission. This “largely worthless” start-up scene, according to the research firm CB Insights, has raised an estimated $238 billion over the last five years — a remarkable bull run in private technology stocks. Forbes reports that there are now close to 200 “unicorns,” to use the Valley term of art for private companies worth more than a billion dollars on paper. Since the financial crisis, these companies, along with their more established public predecessors, have been seen by many Americans as the last redoubt of confidence and productivity in an otherwise uneven recovery. V.C.s have spent years dismissing speculation about a private-equity bubble as merely an expression, by know-nothing spectators, of resentment and alarmism; media onlookers, they argue, should talk instead about the triumphal progress of the genuinely great start-ups as they try to solve our most difficult problems. Over the past year, however, as allegations of mismanagement and unsustainability have grown — Square went public for approximately half its last private valuation; Fidelity and other large mutual funds wrote down their positions in Dropbox, MongoDB, and Snapchat; and both Zenefits and Theranos were accused of deceptive practices — that confidence has come to look more like hubris.

Venture capital increasingly represents a closed system — a system where it is no longer so easy to distinguish good money from bad.

This past January, after a long autumn of minor misfortune left the market in a stall, I spent a week loitering in the command concourse of American V.C., Sand Hill Road in Menlo Park, Calif., where the soft, spruce-filtered sunlight falls through plate glass into quiet offices of beige on beige. There was some selection bias at work, as all my introductions were brokered by a smart and thoughtful friend, but not a single investor I talked to fit the description of the supercilious techno-optimist — and most, in private, didn’t hesitate to concede Palihapitiya’s point. Of course they believed private valuations had become preposterous; of course the run in private tech stocks couldn’t possibly last; and of course, many start-ups, especially those of the “Uber for garden-gnome rearrangement” variety, are in fact largely worthless.

Where they differed from the naysayers, however, was in their rating of the ­causes­ and consequences; the fault, they said, didn’t belong to the technological elite but to everybody else: What has driven inflated valuations, in a time of extremely low interest rates and meager returns elsewhere, is “dumb money,” all the alien capital that has flowed into the Valley in recent years. Dumb money is a hedge-funder who’s jealous of a V.C. Dumb money is sovereign wealth. Dumb money is an Emirati home office. Dumb money is a Facebook millionaire in a Maserati who wants to look like a player. Dumb money wants to get in on tech because it’s a box to check off. Dumb money isn’t in it for the long run. Dumb money doesn’t actually care about the technology. Dumb money doesn’t create value. Dumb money thinks what you lose on the margin you’ll make up for in volume. Dumb money wants to get in on Uber at any price, and will accept a “limited-edition private offer” to join the scarce ranks in a “special purpose vehicle” that bears all the risks of one company with none of the hedging benefits of a portfolio. Dumb money is those pinkish guys with bull necks in Zegna suits. The weird thing about dumb money, unfortunately, is that it can act with fiendish intelligence, insisting on stipulations that guarantee returns at the expense of founders, employees and other investors.

Luckily for the American economy, the dumb money this time around is no longer a mob of deluded pensioners waist-deep in Webvan. (It’s also, the V.C.s noted, a lot less money in total, and at least in theory it’s coming from people who can afford the losses; the last dot-com crash erased an estimated $6.2 trillion in household wealth.) So the coming correction will allow the smart money to roll up its brushed-microfiber sleeves and get back to basics. A lot of $10 billion companies will become $1 billion companies, and $1 billion companies will be acquired for $100 million, and the dumb money will slink away. Operating expenses and burn rates will come way down, and companies that didn’t worry about profitability or unit economics will. There will be layoffs, sure, but the only serious effects will be that the traffic on I-280 will no longer back up three exits, it’ll be easier to get a table at the Village Pub and engineers three minutes out of Stanford will no longer expect $150,000 a year and backlit fountains of complimentary fruit water.

Credit Illustration by Andrew Rae

The main thing that has changed since January is that very little seems to have changed. V.C. investment over the first quarter of the year has remained flat, at about $12 billion, from the final quarter of 2015, though a flight to perceived quality has caused both a drop in the total number of deals and a concentration at the top. The total number of tech I.P.O.s, however, was zero. Yet the flood of money to the Valley has not abated: according to The Wall Street Journal, this has been the single biggest fund-raising quarter for venture capital since the (in retrospect) ominous year 2000.

Bill Gurley, a partner in the firm Benchmark Capital, recently published a blog post in which he reminded his colleagues, in a tone of exaggerated mildness, that table stakes in the industry have perhaps become too high. “Loose capital allows the less qualified to participate in each market. This less qualified player brings more reckless execution, which drags even the best entrepreneur onto an especially sloppy playing field.” Despite warnings like these, companies and V.C. firms have continued to court as much of that loose capital as they still can; almost a decade of aggressive growth strategy, by even the most prudent, demands it. With an utterly dead I.P.O. market, and no appetite among the big public tech companies to acquire companies with bad balance sheets, venture capital is less liquid than ever, and thus increasingly represents a closed system — a system where it is no longer so easy to distinguish good money from bad.

Defenders of that system argue that all they really need are the expected half-dozen mega-I.P.O.s (Slack, Palantir, Snapchat, Uber, Airbnb) to make enough cash returns to offset the losses. But that fantasy math holds for only a tiny cohort of V.C. firms. It also overlooks the well-being of tens of thousands of employees, especially support staff, who have worked for years for a share in the wealth they’ve created. Perhaps worst of all, it betrays a callow belief that the genuinely transformative long-term endeavors that V.C.s have come to support — erstwhile academic research into artificial intelligence, bioengineering and sustainable energy — will be somehow insulated from an industry downturn. An exploded bubble could very well mean that those “totally audacious” bets will go unfunded entirely. That might seem like a satisfying comeuppance for the imperious Valley, but it’s not something to be smug about. Smart money convinces itself of its highly differentiated intelligence at what might prove to be all of our expense.

As a founder, you may be tempted to jump the gun on raising money to fund your business, but it’s worth considering a few things first before you go knocking on investors’ doors. For an emerging company, timing truly is everything, and your decision on when and how to raise the money could spell out success or disaster, depending on how you formulate your strategy.

Nine entrepreneurs from Young Entrepreneur Council (YEC) share the variables you must take into account before going out to raise a round of funding for your business.

1. Your valuation.

There are so many different factors that can change the valuation of your company. Try to build up your company value as much as possible before going out to raise funds. Once you feel that you’ve done everything possible to maximize your positioning, then go out and raise.–Ayelet Noff, Blonde 2.0

2. Your goals for the funds.

While considering a raise, be absolutely clear about why you need the money. You should be able to articulate exactly where you are now, where you want to go and how the money will help you get there. Be as detailed as possible with your “use of proceeds” and weave the financial resources into your roadmap and strategy. You must be able to share this same story to investors and substantiate it.–Andrew Thomas, SkyBell Video Doorbell

3. Whether you need to raise funding.

First, ask if you really want to give up some control over the direction and operations of your firm. Bootstrapping LexION Capital was not easy, but the benefits were well worth it. I’d encourage any owner to do the same: if you can self-fund, you don’t face the prospect of limiting your dream to the time frame and strategy your investors want. You retain total ownership of your firm and your vision.–Elle Kaplan, LexION Capital

4. When you’ll need funding.

Assuming that you’ve decided that you need the money, you should spend some time determining how quickly you’ll need it. Venture money (if your company is qualified) takes a long time, and often grant money takes even longer. Bank loans or friends and family investments can take much less time. Obviously there are other considerations, like how much of your company you’re willing to give up, or if you’re willing to take on debt.–Kofi Kankam, Admit.me

5. What you’ll use it for.

By far the most important factor to consider before deciding to raise money for your business is what you’ll use it for. The proper way to evaluate your needs is by creating a use of proceeds, which is an analysis of your cash needs over a specific period of time (typically 24 months) to accomplish your goals. Goals should focus on growth such as hiring, advertising and software development.–Obinna Ekezie, Wakanow.com

6. Timing.

Is it the right time? Often, you only get one chance to impress investors. Ask yourself, “Does the business need money at this time?” You don’t want to try to raise funds until it is necessary for the success of your business. You also need to make sure that you have your business in order, and you have to be prepared for the scrutiny you will face from investors.–Chuck Cohn, Varsity Tutors

7. Product-market fit.

Raise money to scale what you are already doing that is working. If you don’t have product-market fit, do not raise money — you’ll only anger potential investors, so use your own money to figure that out. Work with people you trust, but don’t give more than 10 percent of your company away during this phase. If you do choose to raise money, raise less than $200,000. Without market fit, you’re doomed.–Adam Root, SocialCentiv

8. How much money you need.

With unicorns abounding today, the temptation to raise big money is huge. But over-raising is even worse than under-raising, as you can always raise more, but you can’t “divorce” your existing investors or terms. Make sure you are only raising enough for a well-conceived, thoughtful and detailed strategy.–Afif Khoury, SOCi, Inc

9. Your audience.

If you don’t understand your audience, you won’t be able to build a sustainable business. Before you look into raising money for your business concept, be sure that your product and/or service is really solving the problem that your audience has in an efficient and cost-effective way. You need to be secure in the fact that your audience will buy and love what your business is offering.

The purpose of a business—any business—is to generate shareholder wealth. A lot of businesses aim to raise capital during their various initial phases. It’s tempting to try and get funding in the beginning, while your ideas are still forming. Getting a lump sum of cash at the beginning could cost you: a big chunk of the company, board seats, and/or control. Instead, why not focus on steadily earning revenue while keeping the company your company?

Many entrepreneurs fall into the trap of raising capital because they’ve been told this is where to start. So how can you have a successful company without resorting to venture capital? Entrepreneurs should follow these few steps to maintain autonomous control of their companies.